Analyst warns DBS will continue to lag

The three Singapore banks that we believe investors would typically consider in a basket are: DBS, OCBC, and United Overseas Bank. On a valuation gap basis, limited outlook for margin improvement, rising liquidity risks, and the potential for credit costs to rise in Hong Kong / China argue for DBS to continue to derate relative to OCBC and UOB. In our view, the notion of a basket trade best applies to Singapore banks.

Valuation gap between DBS and UOB: Slightly above mean.
Reversion to mean? No -- we think that DBS's valuation discount to both OCBC and UOB is likely to persist in the new normal interest rate environment. This is because DBS suffers from overexposure to the markets that are most linked to the US Federal Funds rate, ie, Singapore and Hong Kong. With CASA of over 60% of deposits, DBS's funding position is without question highly superior to both peers in Singapore due to its POSB unit, which is a sustainable advantage in our view, but also its corporate cash management business. But this doesn't generate superior returns in a near-zero rate environment. Additionally, its deposit franchise in Hong Kong is weak, which is reflected in high HK dollar LDR.

We do not hold a negative opinion of the current management, but we believe that the bank's profitability will remain below peers until short term rates rise, at which point DBS would likely re-rate because its margins would expand faster than those of UOB or DBS. But this is a 2013 story -- if we're lucky. In the meantime, a limited outlook for margin improvement, rising liquidity risks, and the potential for credit costs to rise in Hong Kong / China argue for DBS to continue to derate relative to OCBC and UOB.

Valuation gap between UOB and OCBC: Below mean.
Reversion to mean? No -- the valuation differential for UOB and OCBC rarely moves to significant gap levels. We would note that OCBC tends to trade at a slight discount during crisis markets (ie, 2008-09) and a premium during bull market booms (2007, and to a lesser extent 4Q10-1Q11). This suggests higher Beta for OCBC, which is intuitively backed up by its more aggressive growth strategy in recent quarters as well as the volatility of insurance returns, which in part are based on market movements. This highlights the key structural differences between the two groups, as UOB is far more bank-centric while OCBC is more of a financial supermarket.

Where the valuation gap is heading from here depends on market sentiment and risk appetite. We think that OCBC should outperform UOB during bull markets and underperform UOB during bear markets. Excessive asset growth at OCBC Bank in recent quarters points to potential higher credit risk, while the sharp rise in USD LDRs in the past year is also a concern. Insurance earnings are not likely to bolster results in upcoming quarters. The private banking subsidiary is small, but growing and good for sentiment when markets are climbing. However, we are concerned about the rising fixed costs, which may reduce overall profitability unless AUMs can achieve critical mass. While we think this will occur in the longer term, our preference remains with UOB as the more defensive pick.